CHAPTER 7

INTERST RATES
Presented by:
Fabio Bolanda Sandi 20160420182
Puspa Ayu Wulandari 20160420187
M. Naufal Augustian 20160420281
Novita Rahmawati 20160420312
 THE COST OF MONEY
Production Opportunities

The investment opportunities in productive (cash-generating) assets.

The Preferences for Consumption

The Preferences of consumers for current consumption as opposed to saving for future
consumption.

Risk

In a financial market context, the chance that an investment will provide a low or negative return.

Inflation

The amount by which prices increase over time.

 INTEREST RATE LEVEL
Market L : Low-Risk Securities Market H : High-Risk Securities
% % S1
S1 S2
S2
rL = 8
7
rL = 5
4

D
0 Dollars 0 Dollars
THE DETERMINANTS OF MARKET INTERST RATES

Quoted interest rate = r = r* + IP + DRP + LP + MRP

 THE DETERMINANTS OF MARKET INTERST RATES

a. The Real Risk-Free Rate of Interest,

The real risk-free rate of interest is the interest that would exist on a riskless
security if no inflation were expected. The real risk free rate is not static, its
changes over time depending on economic condition. Especially on the rate of
return that corporations and the other borrowers expect to earn on productive
asset and peoples time preferences for current versus future consumption.
 THE DETERMINANTS OF MARKET INTERST RATES

b. The Nominal, or Quoted, Risk-Free Rate of Interest, = + IP

The nominal, or quoted, risk free rate plus a premium for expected

inflation : = + IP

If the term risk free rate is used without the modifiers real or nominal, people
generally mean the quoted or nominal rate.
 THE DETERMINANTS OF MARKET INTERST RATES

c. Inflation Premium (IP)

A premium equal to expected inflation that investors add to the real risk-free
rate of return.

inflation has a major impact on interest rates because it erodes the real value of
what you receive from the investment.

The formula of IP : = = + IP
 THE DETERMINANTS OF MARKET INTERST RATES

d. Default Risk Premium (DRP)

The difference between the interest rate on a U.S. Treasury bond and a
corporate bond of equal maturity and marketability.

The average default risk premium varies over time, its tends to get larger when
the economy is weaker and borrowers are more likely to have a hard time
paying off their debts.
 THE DETERMINANTS OF MARKET INTERST RATES

e. Liquidity Premium (LP)

A premium added to the equilibrium interest rate on a security if that security
cannot be converted to cash on short notice and at close to its fair market
value.

A liquid asset can be converted to cash quickly at a fair market value. Real
asset are generally less liquid than financial asset, but different financial asset
vary in their liquidity.
 THE DETERMINANTS OF MARKET INTERST RATES

f. Interest Rate Risk and the Maturity Risk Premium (MRP)

The risk of capital losses to which investors are exposed because of changing
interest rate. MRP is a premium that reflects interest rate risk.

The effect of MRP is to raise interest rates on long-term bonds relative to

those on short-term bonds.

Reinvestment Rate Risk is the risk that a decline in interest rates will lead to
lower income when bonds mature and funds are reinvested.
 THE TERM STRUCTURE OF INTEREST RATE

Describes the relationship between long-

and short term rates.

Deciding whether to borrow by issuing long- or

short term debt and to investors who are
deciding whether to buy long- and short term

Both borrowers and lenders should understand (1)

how long- and short term rates relate to each other and
(2) what causes shifts in their relative levels
 THE TERM STRUCTURE OF INTEREST RATE

U.S Treasury Bond Interest Rates on Diff Dates

16.0%
14.0%
INTEREST RATE (%)

12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
1 year 5 years 10 years 30 years
May 2011 0.2% 1.8% 3.2% 4.3%
February 2000 6.2% 6.7% 6.7% 6.3%
March 1980 14.0% 13.5% 12.8% 12.3%
 WHAT DETERMINES THE SHAPE OF
THE YIELD CURVE

Because maturity risk premiums are positive, if other things were held
constant, long-term bonds would always have higher interest rates than
short-term bonds.
 WHAT DETERMINES THE SHAPE OF
THE YIELD CURVE
Treasuries have essentially no default or liquidity risk, so the yield on a treasury bond that
matures in t years can be expressed as follows:
T-bond yield = + +

The yield on a corporate bond that matures in t years can be expressed as follow:
Corporate bond yield = + + + +

Corporate bond yield spread = Corporate bond yield Treasury bond yield = +
 USING THE YIELD CURVE TO ESTIMATE
FUTURE INTEREST RATES

We can use the yield curve data to help predict future short-term
interest rates. In the absence of a maturity risk premium, an upwardly
rising government yield curve means that the market expects future
short-term interest rates to increase.
MACROECONOMIC FACTORS THAT INFLUENCE INTEREST
RATE LEVELS

1. Federal Reserve Policy

2. Federal Budget Deficits or Surpluses

3. International Factors

4. Business Activity
 MACROECONOMIC FACTORS THAT INFLUENCE
INTEREST RATE LEVELS

1. Federal Reserve Policy

The money supply has a significant impact on the level of economic activity, the inflation rate and the interest

rate. In the United States, the Federal Reserve governing council controls the money supply. If the fed wants

to stimulate the economy, the fed will increase the growth of money supply, but the initial impact of this

action is the decline in interest rates. Lower interest rates also cause foreign citizens with US bonds to sell the

bonds
 MACROECONOMIC FACTORS THAT INFLUENCE
INTEREST RATE LEVELS

2. Federal Budget Deficits or Surpluses

If the federal government spends more than it takes in as taxes, it runs a deficit;
and that deficit must be covered by additional borrowing (selling more treasury
bonds) or by printing money. If the government borrows, this increases the
demand for funds and thus pushes up interest rates.
 MACROECONOMIC FACTORS THAT INFLUENCE
INTEREST RATE LEVELS

3. International Factors
Businesses and individuals in the united states buy from and self to people and
firms all around the globe. If they buy more than they sell, they are said to be
running a foreign trade deficit. When trade deficits occur, they must be financed;
and this generally means borrowing from nations with export surpluses.
 MACROECONOMIC FACTORS THAT INFLUENCE
INTEREST RATE LEVELS

4. Business Activity
Because inflation increased from 1972 to 1981, the general tendency during
that period was toward higher interest rates. However, since the 1981 peak, the
trend has generally been downward.
The demand for money and the rate of inflation tended to fall and the federal
reserve tended to increase the money supply in an effort to stimulate the
economy.
During recessions, short-term rates decline more sharply than long-term
 INTEREST RATE AND BUSINESS DECISIONS

If we use short-term debt, we will have to renew the loan every year; and the
rate changed on each loan will reflect the then current short-term rate.
If we use long-term debt, the interest cost would remain constant per year, so
an increase in interest rates in the economy would not hurt us.
Financing decision would be easy if we can forecast accurately the future
interest rates, but its impossible. In this case we can mix both short-term and
long-term debt.
THANK YOU